DP10219 Optimal trade policy with monopolistic competition and heterogeneous firms

Author(s): Jan I. Haaland, Anthony Venables
Publication Date: October 2014
Keyword(s): heterogeneous firms, monopolistic competition, productivity, terms of trade, trade policy, variety
JEL(s): F12, F13
Programme Areas: International Trade and Regional Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10219

This paper derives optimal trade and domestic taxes for a small open economy containing a monopolistically competitive (MC) sector in which firms may have heterogeneous productivity levels. Domestic protection brings gains from expanding the number of product varieties on offer, but these gains (and the corresponding rates of domestic subsidy or of import tariffs) are reduced by heterogeneity of foreign exporters who may withdraw from the market. Our analysis encompasses special cases in which the domestic MC sector can expand or contract flexibly, or is of fixed size. In the latter case gains from protection arise from terms of trade effects and, since various margins of substitution are switched off, only the relative values of domestic taxes, import tariffs and export taxes matter.